Greek CDS Surges To All Time Record On Talk Accord For Greek Bailout Faces Major Obstacles

Nobody could have seen this coming. According to RanSquawk, there is "Market talk that accord on new Greek bailout faces major obstacles." Whether true or not is irrelevant: the market sells first. Greek CDS just hit 1,474, +63 bps and an all time record high. Elsewhere, the EURUSD is dropping as the house of cards appears to be finally on the edge.

And the original story from Market News:

PARIS/ATHENS (MNI) - The need for a new Greece bailout deal is growing more urgent, but serious obstacles remain and it is not yet certain that officials will be able to craft an accord satisfactory to all constituents, senior EU and Eurosystem sources told Market News International.

Tuesday's request by German Finance Minister Wolfgang Schaeuble for a seven-year extension on Greek debt has crystallized the debate, underscoring the divide between Berlin and the European Central Bank over involving private creditors in any new bailout package.

Despite public declarations last Friday that an agreement in principle had been reached, two major problems threaten to block a deal, the sources said.

One is the highly sensitive issue of private sector contribution. The other is the insistence of European officials and the International Monetary Fund that the Greek parliament pass significant new deficit-cutting measures before EU leaders meet at the end of June as a condition for new money. That task appears Herculean, given the rapidly growing domestic political and social resistance.

In addition to the tens of thousands of protesters surrounding parliament almost daily, Greek Prime Minister George Papandreou also faces increasingly angry opposition from senior members of his own party, both in the cabinet and in parliament.

The anger is directed at new proposals dictated largely by the European Commission, the ECB and the IMF -- the "troika" -- to cut thousands more public sector jobs, raise taxes further and sell off at least E50 billion in state assets over the next four years.

"As we speak, it is not clear whether the Greek government will be passing the medium-term fiscal plan and the privatization program from parliament before the end of the month," said one senior EU source. "And that is a delay which give an excuse to certain European governments to delay the deal."

For now, this source said, the plan is still for the EU and IMF to pay Greece a E12 billion loan tranche from the current E110 billion bailout package around July 8 and "commit in principle" to new aid that includes participation of the private sector.

Payment of that E12 billion will keep Greece going financially for at least a few more months in case it takes longer to put a new financing package in place.

"Since there is disagreement as to how the [private sector creditor] participation will be carried out, the final details of the plan could take us up to September, when the next tranche of the current loan will be discussed," a senior Eurosystem source cautioned.

Because Greece is now not expected to regain market access next year, or perhaps even in 2013, officials believe it will need about E70 billion in additional funds starting in 2012, with some reports putting the number as high as E100 billion. The current plan, approved in May 2010, assumed the country would return to capital markets in 2012.

The IMF was unwilling to pay its share of the current loan unless there was agreement on a new bailout. With the agreement in principle, it seems to have softened that position. But if there is still no concrete deal by September, the next tranche of the current package due then could be threatened.

For now the deal is being held hostage not just to Greek politics but also to the increasingly open and often virulent dispute between Germany and the ECB over private creditor participation in a new bailout.

In his letter to fellow Eurozone finance ministers on Tuesday, Schaeuble demanded that Greece be allowed to exchange its outstanding bonds for new ones, extending their maturity by seven years. "All additional financial support for Greece must include fair burden-sharing between taxpayers and private investors and must help Greece return to solvency," Schaeuble wrote, according to media reports.

In the past few days, the three major rating agencies -- Standard & Poors, Moody's and Fitch -- have all weighed in, declaring that they would likely regard such an approach as a de facto default.

The ECB has spoken out in the strongest terms against the German approach, warning that even a so-called "soft restructuring" or "reprofiling" would have dire consequences for Greece and could impact other Eurozone states. The central bank itself is the largest holder of Greek bonds, with about E45 billon on its balance sheet.

"In a sense the ECB is in a bind," said another Eurosystem central banker. The central bank agreed to buy Greek bonds under pressure from the governments last year, "and now there is talk of possible haircuts, which devalues the underlying assets that have been used as collateral and are being held on the ECB's books. That was not part of the original understanding and, if you like, it has changed the rules of the game."

More recently, however, the ECB has expressed willingness to consider a deal in which holders of Greek bonds would agree, upon maturity of their holdings, to reinvest the proceeds in new Greek paper, thus reducing the financing need of the government in Athens. This so-called "Vienna Initiative" was used to ease the debt burden of some eastern European states in 2008-2009.

However, Schaeuble said in his letter that private sector involvement in any new deal must "go beyond a simple Vienna initiative."

Whether we're talking about the German approach or a softer one acceptable to the ECB, it is hard to see what incentives could be offered to encourage enough private sector participation to make a tangible difference for Greece.

After all, investors would have to accept far less than the current 16.5% market rate on seven-year Greek bonds, otherwise their participation would only be counter-productive. Anyway, like the rest of the market, they expect Greece to default sooner or later.

The ECB believes that assurances must be given to bondholders in order to ensure that enough of them will agree to participate, the senior Eurosystem source said. The ECB is proposing that private sector participation "should not exceed E20 billion and should come mainly from the Greek banks and institutions that share a common interest for the success of the Greek plan," the official said.

There should also be incentives, he continued. One idea is for the European Financial Stability Facility to guarantee the new bonds or even to buy paper issued by the Greek debt agency. But this is meeting with resistance from Germany and other countries.

Another idea is for Greece to put up collateral as a guarantee against the new bonds. This might include real estate and other state-owned assets. "ECB has stated many, many times before, that Greek real estate should be a driving force behind the reduction of the debt," the senior Eurosystem official reminded.

All of these issues are being discussed by a task force formed by the European Council to discuss a new aid package.

The wrangling over Greece -- and particularly the uncertainty about whether private creditor participation might be considered a default -- may well be one of the factors holding up publication of European bank stress test results, which has been pushed back from June to July.

As the second Eurosystem central banker noted, "there will be no [test] scenarios with a re-profiling of Greek debt. It's all held to maturity under the tests."

Meanwhile, the ECB remains firm on separating interest rate policy from events in the EMU periphery. It is likely to increase interest rates in July and will probably signal such a move at its press conference this Thursday.

"I think with inflation the way it is, you would expect another move soon," said the second Eurosystem source. "And the real economy justifies that. It also sends the right signal as you move into the autumn wage negotiating round. There's no reason to hold off."